Friday, July 2, 2010

Indian Reform Story - Oil in Storm

Dear Readers,

The govt of India decided last week to partially deregulate fuel prices as a step toward financial reforms which started widespread dissent among opposition parties as well as common people . India is a net importer of Crude Oil and it burns up a big hole in Indian budget every year. Govt of India subsidizes refined petroleum products like kerosene, LPG, petrol and diesel in the name of serving the poor and middle class people. Fuel is retailed mainly by PSU (Public Sector Undertaking) firms and these firms are compelled to take losses owing to this subsidy (there are measures taken like 'oil bonds' from time to time to offset some of the losses though). This is an important issue and I felt compelled to post my views on it.

Some Facts

let me start my analysis with some interesting facts about Indian Oil Story.

  • Petrol, Diesel, LPG and Kerosene are main fuels. Except petrol, the other three are considered 'fuel for common man' by political class. 
  • Govt of India controlled fuel prices till 2002 through Administered Price Mechanism (APM) and then after abolishing APM, it continued subsidizing 'sensitive' fuels. Today, losses incurred due to subsidy by PSU Oil Marketing Companies (OMC) is partially offset by upstream PSUs (ONGC, Gail etc) which is not sufficient enough though.
  • Taxes on fuel are very high but still well below European Developed Countries. These taxes, most of which are imposed by state governments, make a fuel cost about double its actual price.
  • India is one of the largest buyers of crude oil in the world (In 2009, India imported 2.56 million barrels of oil per day!).
  • Fuel subsidy costs about USD 40 to 50 million per DAY losses to just three major OMCs - IOC, BPCL and HPCL ! (this figure depends on USDINR exchange rate and so is changing all the time)
The Debate

After these facts its clear that crude oil import cost is a big drag on Indian budget. All this subsidy is in the name of poor and middle class citizens and so becomes politically tough issue. All parties when in opposition protest any subsidy cut, although if they were in power, they may well themselves find this subsidy a burden. Bajpai led NDA and I K gujral led JF have shown their intent to do away with subsidies when they were in power. So, all this protest is nothing more than cheap game of politics. Talking about common people, why would they like anything costly? They don't care about budget deficit or oil pool deficit, all a person wants is freebies - as much as can be taken.

Then it comes to taxes on fuel. Yes, its quite puzzling why does a govt subsidize something and then taxes it heavily. The petrol that costs about a dollar a liter to consumers, costs only about half a dollar before taxes! Why this nonsense? Well, whatever be the reason, fuel prices remain costly for Indian people despite subsidies.

Now, let us think about how these subsidies actually help the poor and at what cost. Subsidy is never a good idea as any item that is subsidized gets misused instead of getting to the 'poor'. Its an open secret that heavily subsidized kerosene is used first as an 'industrial adulterant' with diesel and then 'export item' for smuggling into Bangladesh which has higher price of kerosene. The poor hardly use it and the ration dealers who are authorized to sell kerosene only fill their ledger with fake sales(no wonder there is always a shortage of quantity). 

Similar is the case for diesel - the fuel of transport in India. Because diesel is subsidized, more and more people want to buy diesel powered cars and SUVs - net result? misuse. Also, it is used in power generators as there are frequent and long power cuts in most of India. 

Another heavily subsidized item is LPG and its also misused 'efficiently' by 'innocent' Indians. Commercial LPG users (restaurants etc) are required by law to use a non-subsidized version of LPG cylinder but they somehow manage to get the domestic version which costs almost half of what a commercial cylinder costs. Then, there are 'smart' car owners, who get their cars fitted with cheap LPG kits and use subsidized LPG cylinders for 'better fuel economy'. All in all, govt subsidies are helping all walks of life! (though that is not what it is intended to do).

There are three groups of people when there is a debate on fuel subsidy in India. First are those who think all fuel should be subsidized so that it remains cheap. Second are those who would not mind non-subsidized fuel provided govt reduce taxes on it so that in the end there is cheap fuel available. Third are the ones who dislike subsidies and actually want even more taxes on all petroleum (read fossil fuel) products. NOT SURPRISINGLY, I fall into third category.

Why We Don't Need Cheap Fuel

I understand many of my readers think I must be crazy, but I have my reasons. Let us first discuss the economics of fuel cost. Fuel is one of the most important ingredients in an economy and its price does affect overall production and consumption and thus economy as whole. If fuel is costly then industry has higher manufacturing cost for goods and higher running cost for services which makes goods and services costlier for consumers. This cost appreciation results in lesser consumption of goods and services which in turn affects bottom-line of businesses negatively. When businesses earn less, they employ lesser number of people which in turn means even fewer consumption of their goods and services. A vicious cycle starts and overall economy suffers. So, is that all about it? NO. Let me elaborate why its not exactly that way. 

First, if there is costlier fuel, people and businesses start consuming less of it and if it is left to market then reduced demand of fuel should result in lower cost. This is simple - law of demand and supply. Some people don't accept this logic as they say a lone attempt by a small country like India can not affect fuel prices as international demand for crude oil is much larger than that of India alone. These people are partially right but given the size of import of crude oil by India, I find there should be at least some pressure on international crude price. 

Second, and more important, I am an environmentalist and have openly expressed my feelings about greenhouse gases and anthropogenic global warming. India is FIFTH LARGEST CO2 producer in the world and most of this is generated by burning petroleum products. When govt of India subsidizes diesel and other petroleum products, it indirectly encourages global warming. This is a moral crime. There is no point in paying people to produce excess CO2. If these products are costlier than there are good chances people would use them judiciously. Also, higher cost of energy through fossil fuels means there will be more attention towards alternative fuels like solar energy and hydrogen fuel cells which are comparatively costlier today. What govt of India does to promote alternative energy? It subsidizes them too! This is ridiculous at best. A better solution is to keep high taxes on petroleum products and low taxes on alternative energy products.

Does this mean I want govt intervention? NO. I am never in favor of govt poking its nose in business affairs and economy and that's why I am against subsidies. However, if it has to be 'something' (and this is the case, govt will always want to do something) then let it be only a policy framework at the heart of which is discouraging fossil fuels and encouraging alternative energy. The best way is to let people decide for themselves and let market do its work independently and freely.


  1. I am a great believer in free market system and hence never liked the regulated prices myself. But, there is something bigger government can do that can make fuel cheaper even when market is allowed to set prices and you know what I am refering to!! :-)

  2. I guess, its currency manipulation? or something else? Pls do tell me....


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